Is Bitcoin The Next ‘Safe Haven ?
Recently, Tesla CEO Elon Musk made headlines post announcing that his company has invested USD 1.5 billion worth in Bitcoin. This might have tempted many existing and potential investors to take a shot at this new investment avenue. But many may have done so without understanding the intricacies of the Bitcoin. The article provides some interesting insights
Bitcoin, a cryptocurrency, is not a new phenomenon. It has been there for around 21 years, starting in the year 2009. However, over the past 12 months its value has surged more than 370 per cent. This was even before Tesla’s investment in Bitcoin. And this is not the first time Bitcoin has been in the news for a meteoric rise in its price. In the calendar year 2017, Bitcoin surged from USD 785.40 to USD 19,345.50, giving absolute returns of a whopping 2,363 per cent.
Originally perceived as a digitally encrypted currency alternative to the traditional currencies controlled by central banks, Bitcoin is now attracting traction from even mainstream investors. Given the gains, should you park your money in it? Let us understand what Bitcoin is all about and how it works, including its journey from 10 cents to USD 47,545. It would then be interesting to explore the subject of whether it is worth investing in Bitcoin while studying the associated risks and rewards. Bitcoin may be here to stay but the question is whether it would be worth adding to your portfolio.
Defining Bitcoin
Bitcoin was created in January 2009 as a currency which is in a digitally encrypted form. This was in the wake of an idea set out by a pseudonymous Satoshi Nakamoto in a whitepaper. The original identity of the person or persons who created the technology is still a mystery. The whole idea behind Bitcoin was to lower transaction fees when compared with traditional online payment mechanisms. Moreover, unlike governmentissued currencies, this currency is operated by a decentralised authority. Bitcoin is known as cryptocurrency.
This means that there are no physical Bitcoins, only the balances are kept in a public ledger that everyone has transparent access to it. All Bitcoin transactions are verified by a massive amount of computing power. Furthermore, Bitcoins are neither issued nor backed by any banks or governments, nor are as valuable such as a commodity like gold. Yet, Bitcoin has gained immense popularity and has triggered the launch of hundreds of other cryptocurrencies, despite it not being legal tender.
Working of Bitcoin
Bitcoins are generally identified with a Bitcoin address, which comprises 26 to 35 alphanumeric characters starting with either one or three. This address remains anonymous and represents the destination of a Bitcoin or a fraction of it. Once the Bitcoins pick up momentum, some entities start establishing exchanges that are similar to stock exchanges in order to enable people to buy and sell Bitcoins against legal currencies such as dollars, euros or pounds. Satoshi Nakamoto proposed the idea of having an open ledger, albeit in an anonymous and encrypted form, which would be publicly available containing all the transactions ever made.
This ledger is popularly known as blockchain. As the ledger is public and open in nature, advocates of this currency system believe that this could help weed out corruption and inefficiencies in the system. Traditionally, financial deals happen when two parties use legal currencies and a third-party organisation, usually a central bank, that assures whether the money is genuine or not. The transaction is then recorded. However, with Bitcoin, a chain of computers is constantly working towards authenticating the transactions by solving complex cryptographic puzzles.
The above graph clearly shows how the Bitcoin has moved till now. Up until 2017, there was not any exponential move in Bitcoin. However, in 2017 it moved from the low of USD 785.40 in January to post a high of USD 19,345.50 in December, giving an absolute return of 2,363 per cent. In 2018, it slipped down from the high of USD 19,345.50 made in December 2017 to post a low of USD 3,229 in December 2018, registering a fall of 83.31 per cent. Though it started recovering from January 2019, it took almost two years to reach its December 2017 levels. And this might be the reason that mostly from January 2019 to December 2020 it was not in the news as such.
However, from the low made in December 2018 it bounced to create all-time high of USD 48,643, generating a CAGR of around 288 per cent and absolute return of 1,407 per cent. Though this seems to be both intimidating and attractive, we also need to understand the risk part of it.
The above table clearly shows the risk return parameters of various investments, including Bitcoin. Although the return from Bitcoin seems to be astronomically high, one cannot overlook its volatility, which is almost 10 times higher than that of equity. Moreover, if we look at the top five drawdowns of Bitcoin and other assets, it seems that it is highly risky as it has lost more than 90 per cent of its value twice in the last 11 years.
The above table also makes it clear that Bitcoin is a higher risk– higher reward investment avenue.
Investing in Bitcoin
We believe for most investors, Bitcoin is something that can be avoided. This is because there are many investors in the country who have not yet properly adjusted with the volatility in equity which is 10 times lower than that of Bitcoin. As such, it makes no sense for such investors to invest in cryptocurrency. This investment should only be used by those who wish to diversify their portfolio and are comfortable with higher daily volatility. In the short-term or even in the long-term Bitcoin can seem to be quite attractive, yet the risk is too high. Therefore, it should not form more than 5-10 per cent of your portfolio.
FAQs
What is Bitcoin or cryptocurrency?
Bitcoin is a consensus network that enables a new payment system and completely digital money. It is the first decentralised peer-to-peer payment network that is powered by its users with no central authority or middlemen. Simply put, Bitcoin is pretty much like cash for the internet.
What is legal status of Bitcoin or cryptocurrency in India?
As of now, there is no crypto regulation in India. However, buying and selling Bitcoin is absolutely legal in India. Presently, there is no such law which prohibits Indians from buying or selling cryptocurrencies in India. There was a banking ban from July 2018 – March 2020 due to which cryptocurrency exchanges were not able to hold bank accounts. But the Supreme Court of India abolished the ban in 2020. India’s Ministry of Finance and Corporate Affairs is likely to propose a bill on cryptocurrencies soon.
Is it safe to invest in Bitcoin?
Like many other investments such as equities, even Bitcoin is not a safe bet. In fact, Bitcoin is a highly volatile investment. It is almost 10 times more volatile than equity.
What is the digital risk of investing in cryptocurrency?
There are no such hacking risks as cryptocurrencies – at least Bitcoin – use blockchain technology which is not possible to hack as of now. However, as there is no backing with assets and no regulation, its prices are purely based on speculations.
Are cryptocurrency transactions taxed?
According to regular Income Tax parlance, tax implications on cryptocurrencies would depend on the investment’s nature, whether held as a currency or held as property. Any gain from the sale of Bitcoin may be taxed as business income if traded frequently or taxed as capital gain if held for the purpose of investment. If regarded as business income, the gains would be taxed as per the applicable slab rate.
However, for investors in Bitcoin, taxation is similar to that of gains through debt mutual funds. This means that if their investments mature before three years, they may have to pay short-term capital gains as per the current tax slab. If the redemption is after three years, any redemption may be treated as long-term capital gain and could be taxed at 20 per cent with indexation benefit.
Conclusion
As of now, Bitcoin may seem to be a hot investment but there could be a downfall waiting in the wings. It is something like gravity – additional force may help you swing high but the certainty of falling down is always 100 per cent. Therefore, if you wish to invest in Bitcoin, first consider your aptitude for absorbing volatility. For most investors in India who still keep their money parked in safe investments, it would be best to avoid investing in Bitcoin.
Further, from a diversification perspective, it should not be more than 5-10 per cent of your portfolio. In our opinion, investing in currency which is not a commodity or a legal form currency should be avoided. Rather, investing in the technology behind it i.e. blockchain would make more sense. In conclusion, looking at cryptocurrency as a trading and investment vehicle defies the very purpose of it.